Like any investment, there are always risks. This is especially true when DeFi is involved. In other words, liquidity pools are becoming more and more popular, and more and more capital is allocated to them. With more and more adoption and greater risks, more and more people are involved than ever before to protect users' funds through carefully coded smart contracts. Still, there are some risks you should know.
1. Eavesdropping on smart contracts
When it comes to liquidity pools, one of the biggest risks is smart contract risk. This is the risk that the smart contract of the management pool may be used by hackers. If hackers can find loopholes in smart contracts, in theory they can use up the liquidity pool of all their assets. For example, hackers can borrow a large number of tokens through fast loans and execute a series of transactions, which will eventually lead to the depletion of funds. This is what happened in the fast loan attack on the balancer protocol in 2020.
This is why it is strongly recommended to only invest in liquidity pools that have been audited by a reputable company, thereby reducing the possibility of dealing with vulnerable smart contracts.
2. High slip point due to low liquidity
Another risk to consider is low liquidity. If a fund pool does not have enough liquidity, it may experience a high sliding point when the transaction is executed. This essentially means that the price difference between executed transactions and executed transactions is large. This is because when the liquidity pool is very small, even a small transaction will greatly change the proportion of assets.
What if you still want to interact with the pool, but do not want to take an unbearable risk of sliding points? Most dexes allow you to set the sliding point limit as a percentage of the transaction. But keep in mind that the low slip point limit may delay or even cancel the transaction. For example, if you are working with several other people to create a much publicized NFT collection, you will want your transaction to be executed before all assets are purchased. In this case, you can set a higher sliding limit.
3. Preemptive transaction
Another common risk is preemptive trading. This occurs when one user tries to buy or sell assets while another user is performing transactions. The first user can buy the asset before the second user, and then sell it back to them at a higher price. This allows the first user to make a profit at the expense of the second user. This mainly occurs in networks with slow throughput and pools with low mobility (due to slippage).
4. Impermanent loss
Volatile loss is the most common risk type of liquidity providers. This happens when the price of the underlying asset in the asset pool fluctuates. When this happens, the value of the pool's tokens will also fluctuate. If the price of the underlying asset decreases, the token value of the asset pool will also decrease. The reason why this is considered a risk is that the price of the underlying asset may always fall and never rise.
If this happens, the liquidity provider will suffer a loss. When asset prices rise sharply, there will also be volatile losses. This causes users to buy from the liquidity pool at a price lower than the market price and sell elsewhere. If the user exits the liquidity pool when the price deviation is large, the transient loss will be "recorded" and therefore permanent. The liquidity pool of low volatility assets such as stable bonds experienced the least volatile losses.
The above are several risks existing in the liquidity pool. When the price of the underlying assets in the pool starts to become very volatile, it is usually a good idea to exit the liquidity pool. This is because when the price of assets in the pool fluctuates greatly, the risk of volatile losses will increase.